A wraparound mortgage transaction has been described as follows:
[A] preexisting mortgage (usually of first priority) on the real estate remains in place, while a new “wraparound” mortgage of second priority, generally for a higher balance, is placed on it. The mortgagor makes payments only on the wraparound mortgage, whose mortgagee in turn makes the payments due on the preexisting or “underlying” mortgage.
Nelson, Whitman, Burkhart, and Freyermuth, Real Estate Finance Law (6th ed.) 2014, § 9.8 (Wraparound Mortgages).There may, under certain circumstances and in certain jurisdictions, be legal issues (discussed below) that occur with respect to wraparound mortgages, including usury, violation of state consumer-protection statutes, and violation of due-on-sale-and encumbrance clauses in the superior mortgage.
Applicability of Usury Laws
The wraparound lender must be careful that the effective yield does not violate the usury laws of the state where the property is located. Some states may consider the effective rate and not the stated rate in the note when determining if the loan is usurious. See, e.g., Skinner v. Cen-Pen Corp., 243 Va. 279, 283-84 (1992). In this case the borrowers signed a $50,000 bearer note (“Note”) that was secured by the second deed of trust on their residence, in return for an advance of approximately $4300. The monthly installments due on the subordinate deed of trust stated an interest rate of 13 ¼% per annum. The note required the borrowers to transmit $472.31 of their monthly payments to the first deed-of-trust note holder to pay their monthly payments on that note. The subordinate lender was then to apply the balance of $116.93 to the monthly payments of principal and interest on the bearer note. The court noted that:
If the amount [the subordinate lender] actually lent to the [borrowers] was $50,000, then the effective interest rate was stated correctly in the note as 13–1/4%. But if the amount actually lent was $4,298.18, then the effective interest rate was 31.22%, although that rate was not stated in the note.
Id. at 281.
The court agreed with the borrowers that the wraparound feature of the subordinate loan did not transform a $4,300 loan into a $50,000 loan. The court ruled that:
[T]he true nature of the transaction was a $4,298.18 loan bearing an effective interest rate of 31.22%. This rate was not stated in the note, as required by Code § 6.1–330.16(F); hence, [the subordinate lender’s] annual interest charge exceeded the maximum [statutory] authorized interest rate of 8% by 23.22%.
Id. at 284.
Applicability of Due-on-Sale-and-Encumbrance Clauses
It would seem that the enforceability of a due-on-sale clause would not be impacted by the existence of a wraparound mortgage. The Garn-St Germain Depository Institutions Act of 1982, 12 U.S.C. § 1701j-3 et seq. (1982) ("Act"), provides for the federal preemption of any limitations on the exercise of due-on-sale clauses imposed by state law. Since the passage of the Act, mortgage lenders generally have assumed that they no longer need to concern themselves with potential legal challenges to the validity or enforceability of such clauses in their mortgage loan documents because of the Act’s preemptive effect. The final regulations issued in connection with the Act make this preemption very clear. See 12 c.f.r. § 591.1(b),
Most due-on-sale clauses in commercial mortgage-loan documents also contain due-on-encumbrance language, which provides that the lender may accelerate the loan if the borrower further encumbers the subject property without the first mortgagee’s consent. But the wording of the clause must be precise and specifically cover all forms of subordinate mortgage lending and not refer, e.g., merely to violation of the clause due to an “assumption” of the loan by a subsequent purchaser. Some courts may also focus on whether the first mortgagee has delayed an unreasonable period of time after discovering the transfer or encumbrance but before accelerating the debt. Waiver or estoppel may also apply against the first mortgagee based on its statements or course of action before (or even after) the additional encumbrance of the property by the mortgagor, such as knowingly receiving and accepting mortgage payments from the wraparound lender for a period of time after the unpermitted encumbrance.
The first mortgagee may also run the risk of having agreed to the wraparound subordinate mortgage if it delays an unreasonable period of time after discovering an unpermitted transfer but before accelerating the debt. Waiver or estoppel may also apply against the first mortgagee based on its statements or course of action before (or even after) the wraparound mortgage is placed of record, such as knowingly and continuously receiving and accepting mortgage payments from the wraparound lender for a period of time after the unpermitted encumbrance.
Conclusion
The usual wraparound note and mortgage contain language requiring the wraparound lender to make payments directly to the mortgagee of the superior loan, but only on the condition that the borrower on the wraparound loan also makes the required payments to the lender under the wraparound loan. Wraparound mortgage financing is not as common now as in the past because of the current interest-rate environment, and the knowledge and comfort (based on a significant body of case law) that prior mortgage lenders have with respect to the enforcement of comprehensive due-on-sale-and-encumbrance clauses in their mortgage-loan documents. But such financing could again become a major factor when interest rates rise from their current historical low levels. Both borrowers and lenders considering wraparound financing should be certain to specifically address the issues raised in this article before proceeding with such financing.
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